Within the past decade, Exchange Traded Funds, commonly referred to as ETFs, have exploded onto the scene and are quickly becoming many investors’ go-to choice for index-like exposure. Similar to an index-based mutual fund, each share of an ETF represents a fractional ownership in a basket of assets making up a particular underlying index. By purchasing the index in aggregate through an ETF, rather than purchasing each asset independently, investors can receive their desired exposure with just one trade and one position. Although ETFs are a new concept to many investors, the investment community as a whole has embraced ETFs for some time. Total ETF assets are set to eclipse 3 trillion dollars this year1, and the world’s largest ETF, the State Street SPDR® S&P 500® Index ETF (SPY), held over 176 billion dollars in assets as of July 31st, 20152. Some of the benefits of ETFs are outlined below, using SPY as an illustration:

Low Cost: The average ETF has a net expense ratio of 0.44% which equates to $44.40 in annual fees for a $10,000 investment3. Many of the large index ETFs have expense ratios that are even lower. SPY, for example, has a net expense ratio of 0.0945%, which equates to roughly $9.50 in annual fees for a $10,000 investment2.Within the past decade, Exchange Traded Funds, commonly referred to as ETFs, have exploded onto the scene and are quickly becoming many investors’ go-to choice for index-like exposure. Similar to an index-based mutual fund, each share of an ETF represents a fractional ownership in a basket of assets making up a particular underlying index. By purchasing the index in aggregate through an ETF, rather than purchasing each asset independently, investors can receive their desired exposure with just one trade and one position. Although ETFs are a new concept to many investors, the investment community as a whole has embraced ETFs for some time. Total ETF assets are set to eclipse 3 trillion dollars this year1, and the world’s largest ETF, the State Street SPDR® S&P 500® Index ETF (SPY), held over 176 billion dollars in assets as of July 31st, 20152. Some of the benefits of ETFs are outlined below, using SPY as an illustration:

Diversification: ETFs allow an investor to conveniently buy and sell broad, diversified exposure. To illustrate this point, we calculated that an investor would need about $270,000 to create an S&P 500 proxy portfolio, plus the costs of trading all 503 component stocks4. SPY, on the other hand, can be purchased in roughly $200.00 increments5, plus the cost of trading the ETF, and provide the same S&P 500 proxy exposure as the expensive $270,000 portfolio that we proposed above. ETFs can also provide diversification among different asset classes as they track a large number of different asset classes and sub-asset classes.

Transparency: Many of the large ETFs update fund holdings daily and the listing exchange of each ETF is required to publish an intraday net asset value (“iNAV”) every 15 seconds, compared to mutual funds which generally reveal holdings quarterly and publish net asset value (“NAV”) once at the end of the day.

Convenience: Like any regular stock, the shares of an ETF are traded on exchanges and can be bought and sold at any time during market hours. As a result, buyers and sellers have a much better idea what price they will pay or receive than they would with mutual funds, which are bought and sold at the end-of-day NAV regardless of when the order is placed prior to the market close.

ETFs vs. Mutual Funds

Comparing ETFs to mutual funds requires an important distinction between active and passive mutual funds. Active mutual funds employ an active investment strategy, generally with the goal of outperforming an index with similar characteristics to the fund. Unfortunately, however, most active mutual funds historically underperform their index6, and the primary reason is obvious when you consider how expensive active mutual funds are.

“The Real Cost of Owning A Mutual Fund”7

Account Type

Expense Ratio

Transaction Costs

Cash Drag

Tax Cost

Total Costs

Cost per $10,000

Taxable

0.64%

0.53%

0.20%

0.91%

2.28%

$228.00

Non-Taxable

0.64%

0.53%

0.20%

0.00%

1.37%

$137.00

Looking at the table above, in a taxable account the fund needs to return over 2% in excess of the market to justify the cost. This is without considering potential load fees which occur when an investor purchases the fund and can be as high as 5%. While there are select managers who can consistently accomplish this feat, the list is short. Passive mutual funds are somewhat less expensive, but they can only mitigate the expense ratio and transaction costs. When it comes to mutual funds, cash drag and tax costs aren’t a choice—they are a result of structure.

When a person invests in a mutual fund, they deliver cash and receive newly created shares. These shares are “non-negotiable”, meaning they are not easily transferable to another person. When these shares are redeemed, they are destroyed and cash is given to the investor. This cash needs to come from somewhere, so to facilitate these redemptions, mutual funds retain cash in the portfolio. Furthermore, if cash levels get too low the mutual fund will liquidate securities, potentially resulting in a taxable gain which may be distributed to the remaining shareholders. ETFs solve both of these problems. ETFs are “negotiable”, meaning they are easily transferable to another person. Shares are bought and sold between investors on an exchange, relieving ETFs of any required cash holdings. Additionally, because the fund doesn’t buy or sell any holdings during the transaction, it avoids accruing taxable gains.